ACV - ICVT: Low-Cost Convertible Bond Exposure Outperforms Active CEFs
2023-04-19 08:46:57 ET
Summary
- The ICVT ETF provides a low-cost way to gain convertible bond exposure.
- During bull markets, convertible bonds can deliver equity-like returns due to their embedded options.
- I believe the ICVT is a relative buy compared to actively managed convertible bond CEFs. ICVT has higher total returns and lower volatilities.
The iShares Convertible Bond ETF ( ICVT ) provides a low-cost way to gain convertible bond exposure. For total-return focused investors, I believe the ICVT ETF is superior than the actively managed CEFs focused on convertible bonds. ICVT has superior returns and lower volatilities. I rate the ICVT ETF as a relative buy.
Fund Overview
The iShares Convertible Bond ETF tracks the performance of an index composed of U.S. dollar-denominated convertible securities with outstanding issue sizes greater than $250 million.
The ICVT ETF has $1.2 billion in assets and only charges a 0.2% expense ratio.
Introduction To Convertible Bonds
Convertible securities are investments that can change from their initial form into another form after certain conditions are met. The most commonly issued convertible securities are convertible bonds and convertible preferred shares that can be converted into common shares of a company at a given conversion price.
Convertible bonds typically carry lower interest than vanilla bonds, as the 'option' to convert is valuable so investors are willing to accept a lower coupon in order to participate on 'equity upside'. For issuers, they trade off potential share dilution for lower interest costs.
One common way to value convertible bonds is to consider them as a combination of a vanilla bond plus a call option on the underlying stock. In a bull market when equities do well, convertible bonds can perform exceptionally well compared to vanilla bonds as the option component provides upside convexity. Conversely, in a bear market, the option component can lose value very quickly, and so convertible bonds may underperform vanilla bonds.
Portfolio Holdings
Figure 1 shows the ICVT ETF's portfolio characteristics. The ETF has 323 holdings with portfolio 30-day SEC yield of 4.0% and effective duration of 1.7 years.
Figure 1 - ICVT portfolio characteristics (ishares.com)
Sector-allocation wise, the ICVT ETF is heavily geared towards Technology (41.4%), Consumer Cyclicals (20.2%), and Consumer Non-Cyclicals (13.1%) sectors (Figure 2).
Figure 2 - ICVT sector allocation (ishares.com)
Convertible securities are mostly unrated assets, hence ICVT's credit quality allocation shows a high weighting in unrated securities (Figure 3).
Figure 3 - ICVT credit quality allocation (ishares.com)
Distribution & Yield
The ICVT ETF pays a modest monthly distribution with a trailing 12 month distribution yield of 2.0% (Figure 4).
Figure 4 - ICVT distribution yield (Seeking Alpha)
Returns
Figure 5 shows the ICVT ETF's historical returns. Returns have been fairly strong, with 3 and 5Yr average annual total returns of 15.0% and 9.6% respectively to March 31, 2023. This is despite poor 2022 returns of -20.9%.
Figure 5 - ICVT historical returns (morningstar.com)
On an annual basis, we can see that the ICVT ETF had a very strong 2020, returning 61.7%. This is reflective of the convex nature of convertible securities' returns, as explained above. During bull markets, many convertible bonds have reference stock prices trading far above conversion price, hence convertible bonds were delivering equity-like returns in 2020 (Figure 6).
Figure 6 - ICVT annual returns (morningstar.com)
Figure 7 shows the annual returns of the SPDR S&P 500 ETF Trust ( SPY ) as a comparison. Note that in 2020, the ICVT ETF actually outperformed equities, as represented by the SPY ETF, due to the convex-nature of its embedded equity options. However, weak 2021 relative performance for ICVT also shows equity options can lose value very quickly in adverse environments.
Figure 7 - SPY annual returns for comparison (morningstar.com)
ICVT Vs. Active Convertible CEFs
Previously, I have reviewed several convertible bond-focused closed-end funds ("CEFs") like the Virtus Diversified Income & Convertible Fund ( ACV ), the Calamos Convertible Opportunities And Income Fund ( CHI ), and the Ellesworth Growth & Income Fund ( ECV ). How does the passive ICVT ETF compare against these actively managed CEFs?
Figure 8 compares ICVT ETF against these active CEFs using a proprietary scorecard I developed to compare investment funds.
Figure 8 - ICVT vs. Convertible CEFs (Author created with data from Morningstar and Seeking Alpha)
First, in terms of fund structure, there is no comparison. The ICVT ETF's fees are an order of magnitude lower than the active funds, with much lower turnover.
In terms of returns, the ICVT ETF also shines, ranking 2nd or 1st across the measured time-frames.
ICVT's returns were generated with lower than peer volatilities, which leads to the best Sharpe Ratios out of the comparison group.
The only knock against the ICVT ETF is that unlike the CEFs, it does not pay a generous distribution. ICVT's distribution yield is only 2.0%, far lower than the active funds' 5-11%.
As a total return-focused investor, I believe the ICVT ETF's mix of strong historical returns and low volatility makes it the best selection for convertible bond exposure.
Conclusion
The ICVT ETF provides a low-cost way to gain convertible bond exposure. For total-return focused investors, I believe the ICVT ETF is superior than most of the active CEFs focused on the convertible bonds space, with better returns and risk metrics. The only knock against ICVT is its relatively modest distribution yield. I rate the ICVT ETF as a relative buy.
For further details see:
ICVT: Low-Cost Convertible Bond Exposure Outperforms Active CEFs